Cost of Capital Dynamics Implied by Firm Fundamentals

by Matthew Lyle & Charles C.Y. Wang

Executive Summary — Despite ample evidence that expected returns are time varying, there has been relatively little empirical research on estimating the dynamics of firm-level expected returns. Capturing the dynamics of firm-level expected returns is important, because it allows for a better understanding of firm risk over time and can inform investors in tailoring their portfolios to match their desired investment horizons. Findings show that cost of capital is time varying and highly persistent. The authors also demonstrate that the model produces empirical proxies of expected returns that can predict future stock returns up to three years into the future and sorts portfolio returns with near monotonicity. Aside from its practical contributions, this paper adds to a budding finance and accounting literature that studies the properties of expected return dynamics. Key concepts include:

The model can forecast stock returns up to three years into the future and tracks economic conditions.

From a practical standpoint, the approach has several advantages relative to the current methodologies for estimating expected returns. The model is easy to implement, requiring only realized returns, realized BM ratio, and realized ROE.

The model also allows for discount rates to be dynamic and produce a full projection of future—time varying—cost of capital estimates.

On average, the term structure of cost of capital, like the yield curve for bonds, is upward sloping. However, during times of high economic uncertainty, as in recessions and crisis periods, the term structure flattens and can be downward sloping.

Author Abstract

We provide a tractable stock valuation model to study the dynamics of discount rates using only two firm fundamentals: the book-to-market ratio and expected ROE. We find that the model is easily applied to a large cross section of firms and that firm-level discount rates vary over time and are highly persistent. The model can forecast stock returns up to three years into the future and tracks economic conditions. During normal or expansion periods in the economy, the dynamics of cost of capital generate an upward sloping term structure; however, in times of high economic uncertainty, the term structure flattens and can be downward sloping.